Abstract
This study examines whether and how the presence of managerial hedging opportunities, which allows executives to reduce the sensitivity of their equity-based compensation to the firm’s stock price performance, affects firms’ corporate social responsibility (CSR) activities. We find a significant and negative relationship between the presence of managerial hedging opportunities and firms’ CSR performance. The effect of managerial hedging opportunities on CSR performance is more pronounced for CEOs with greater personal hedging needs. Additionally, the effect is weakened if firms limit corporate insiders from trading exchange-listed options. Overall, this study suggests that allowing managers to delink their equity-based compensation from firm stock price performance through hedging their personal portfolios can lead to unexpected consequences for firms’ CSR performance.
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Notes
Agency theory suggests a positive relationship between managerial equity ownership and firm value (Jensen & Meckling, 1976; McConnell & Servaes, 1990) because of potential conflicts of interest between corporate managers and shareholders when managers have little equity ownership of a firm (Berle & Means, 1932). Because it is generally believed that stock price captures the various channels through which CEOs (and other key executives) affect long-term shareholder value (Edmans, 2016; Jensen, 2001), equity-based compensation is widely used as a vehicle to alleviate agency conflicts within a firm by aligning managers’ interests with those of shareholders.
Supporting this argument, Kang et al. (2006) find that greater equity-based compensation is positively related to long-term investment spending as measured by capital expenditures, R&D expenditures, and acquisitions. Similarly, Karim et al. (2015) find a positive relationship between CSR and equity-based compensation.
Prior research finds that firm’s CSR performance is correlated with various institutional- and firm-level factors such as organinzational culture (Galbreath, 2010), institutional environment (Di Giuli & Kostovetsky, 2014; Ioannou & Serafeim, 2012), investor sentiment (Naughton et al., 2019), analyst coverage (Qian et al., 2019), exogenous terrorist attacks (Do et al., 2020), institutional holdings (Dyck et al., 2020), and national-level board reforms (Liao et al., 2021). Recently, studies also provide evidence that CEO characteristics such as altruism (Borghesi et al., 2014), family composiition (Cronqvist & Yu, 2017), marital status (Hegde & Mishra, 2019), and materialism (Davidson et al., 2019) play an instrumental role in shaping the CSR activities. Relatedly, Davidson et al. (2019) find that CEO fixed effects explain 52% to 74% of the variance of firm’s CSR performance.
Hong et al. (2016) find that firms with more shareholder-friendly corporate governance are more likely to link their executives’ remuneration to CSR outcomes. They also show that the inclusion of CSR criteria in executive compensation leads to more CSR activities. Similarly, Flammer et al. (2019) show that the adoption of CSR contracting affects various firm-level outcomes including social and environmental initiatives.
For example, if personal hedging is carried to the extreme, it is possible that executives receive no performance-based incentive from equity ownership or equity-based compensation but receive entirely cash compensation (Larcker & Tayan, 2011, p. 312). Supporting this view, Gao (2010) and Hung et al. (2019) both show that shareholders/boards are likely to adjust CEOs’ compensation contracts when corporate executives can reduce the link between their equity compensation and stock price performance through hedging activities.
McGuire and Argheyd (2003) find salary and long-term incentives have a positive association with weak social performance. Mahoney and Thorne (2005) report a similar relationship between long-term compensation and CSR weakness. Deckop et al. (2006) find that a short-term (long-term) pay focus is negatively (positively) related to CSR. Fabrizi et al. (2014) find that monetary incentives designed to align the CEO’s and shareholders’ interests have a negative effect on CSR, while non-monetary incentives have a positive effect. McGuire et al. (2019) show that CEO pay-performance sensitivity increases the relevance of the consequences from poor CSR, while the duration of CEO compensation reduces poor CSR. Some recent studies investigate the determinants and consequences of CSR-linked CEO contracting (Flammer et al., 2019; Hong et al., 2016).
Firms often employ policies that put some restrictions on managerial hedging. However, Hung et al. (2019) claim that corporate policies that limit/ban executives from hedging may not function effectively because (1) completely eliminating managerial hedging is practically infeasible, and (2) such policies will incur additional monitoring compensation costs. Similarly, Garvey (1997) argue that corporate policy on executive hedging is costly because firms cannot perfectly control individual’s participation in hedging transactions.
The literature suggests that a key driver of CSR at the firm level is a firm’s financial performance/constraints (Campbell, 2007; Orlitzky et al., 2003). Although CSR investment can be costly, studies report positive, negative, and even neutral effects of CSR on financial performance/firm value (McWilliams & Siegel, 2000).
Consistent with this view, Hubbard et al. (2017) show that increasing CSR activities sometimes even increase a CEO’s dismissal risk.
MSCI ESG provides CSR ratings from 1991 for member firms of the S&P 500 and Domini 400 indexes. The coverage was enlarged to include member firms of the Russell 1000 index from 2001 and member firms of the Russell 2000 index from 2003.
When identifying exchange-listed options, Gao (2010) only focuses on the six large U.S. options exchanges. However, due to a series of acquisitions made by the major U.S. exchanges in recent years, it is difficult to apply the same top-six exchanges condition to our study, as the sample period extends to 2016. Therefore, we consider all options exchanges covered by the OptionMetrics database.
One caveat of using Alt. Hedge is that we cannot completely rule out the possibility that the executives’ options trading volume might be correlated with various CEO characteristics. We thank the anonymous reviewer for pointing out this issue. We employ various empirical methodologies to handle this endogeneity concern and discuss them in later sections.
In addition to the six dimensions, MSCI ESG provides performance indicators for corporate governance. We exclude corporate governance in measuring CSR following the majority of studies in the CSR literature. In a later section, we test whether our results are sensitive to the inclusion of the corporate governance dimension and find that our main inference is unaltered.
MSCI ESG modified the scope of its database by dropping off some data items after 2013, which overlaps with our final sample period (2003–2016). To ensure that our results are not affected by the possible inconsistency in measuring CSR performance, we re-estimate the main analysis after removing the observations from 2014 through 2016. In untabulated tests, we find that our results remain qualitatively and quantitatively similar. We further address this concern in ‘Alternative Measures for CSR Performance’ by employing alternative measures for CSR performance.
Alternatively, we measure the CEO’s hedging opportunities variables in year t-1. Untabulated tests find similar results.
In subsequent analyses, we bifurcate the test variables by incorporating firms’ policies that limit or ban executives’ hedging activities. This bifurcation increases the variation of our main test variable.
Since we measure a firm’s litigation risk based on its industry classification, firm fixed effects subsume the effect of Litigation. Therefore, across columns 2 to 4, we remove the variable Litigation from the regression model.
Unlike other matching techniques such as propensity score matching, entropy balancing relieves the covariate differences problem without any sample loss. Therefore, the technique is particularly suitable for our study where the size of treatment and control groups are largely unbalanced.
We further assess the robustness of the main inference using the Granger-style reverse causality minimization procedure (Godfrey et al., 2020). In untabulated tests, we find qualitatively similar results which reinforce the identification of managerial hedging effects on firms’ CSR performance. We thank an anonymous referee for this suggestion.
A one standard-deviation increase in Alt. Hedge (i.e., 2.987) leads to a change of − 0.125 (= 2.987 × − 0.042) in CSR performance (CSR score).
If the Execucomp item shrown_excl_opts is missing, we convert the missing value to zero. The results are robust to restricting the final sample to those having a non-missing value for shrown_excl_opts.
The firm-level political risk score, provided by Hassan et al. (2019) is computed based on a pattern-based sequence classification method used in computational linguistics. We obtain the data from the Firm-level risk webpage (https://www.firmlevelrisk.com/download).
Cook (2019), for example, shows that there is a growing tendency in prohibiting managerial hedging since 2006 when the SEC began requiring firms to discuss in the CD&A section any material hedging policies for their executives (i.e., Item 402(b) of Regulation S-K). The report documents that although the rule did not require firms to forbid executive hedging, some companies started forbidding hedging activities by executives as the safest response to the rule.
The SEC approved the rule requiring the disclosure of hedging policies in annual proxy statements on December 18, 2018. This rule became effective for proxy statements filed in fiscal years beginning on or after July 1, 2019.
In untabulated tests, following Chen et al. (2020), we standardize the CSR score within each year (i.e., each yearly observations will have a mean of zero and a standard deviation of one). We find qualitatively similar results.
We start the sample period in 2002 because the ASSET4 database provides the ESG data from the year, and end it in 2016 due to data availability. The ASSET4 database does not significantly alter its measurement basis throughout the period.
See Appendix for detailed descriptions for each variable. We thank Jee-Hae Lim for providing data on CEO financial expertise.
Due to data availability, the inclusion of future CSR performance measured in year t + 1 (t + 2) reduces the sample period to 2003 to 2015 (2014).
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Appendix
Appendix
Variable | Definition |
|---|---|
<Dependent variables> | |
CSR strength | Summation of the strengths scores of the six MSCI ESG dimensions of CSR, (1) community relations, (2) diversity, (3) employee relations, (4) environmental policies, (5) human rights, and (6) product strategies, in a given year (MSCI ESG item com_str_num + div_str_num + emp_str_num + env_str_num + hum_str_num + pro_str_num) |
CSR concern | Summation of the concerns scores of the six MSCI ESG dimensions of CSR, (1) community relations, (2) diversity, (3) employee relations, (4) environmental policies, (5) human rights, and (6) product strategies, in a given year (MSCI ESG item com_con_num + div_con_num + emp_con_num + env_con_num + hum_con_num + pro_con_num) |
CSR score | CSR performance score in a given year calculated as CSR strength minus CSR concern |
<CEO hedging opportunities variables> | |
Hedge | An indicator variable that equals one if a firm's options are being traded on the exchanges in a given year, and zero otherwise |
Alt. Hedge | Natural logarithm of a firm's total options trading volume (OptionMetrics item volume) in a given year. The options trading volume is scaled by the total number of shares outstanding (Compustat item csho). If a firm’s options are not traded in options exchanges (i.e., Hedge = 0), the value of Alt. Hedge is set to zero |
Hedge-more opps | An indicator variable that equals one if a firm’s options are traded on the exchanges and corporate insiders trade at least one share of options in a given year and zero otherwise. Corporate insiders include top executives and directors. Top executives are CEO, CFO, CIO, COO, and CTO (TR insider item rolecode = “CEO,” “CFO,” “CI,” “CO,” or “CT”). Directors are chair, vice chair, and other directors (TR insider item rolecode = “CB,” “D,” “DO,” “H,” “OD,” or “VC”). We consider a corporate insider to be trading options if they acquire or dispose of (TR insider item acqdisp = “A” or “D”) at least one share of options (TR insider item derivative = “OPTNS,” “PUT,” or “CALL”) in a given year |
Hedge-fewer opps | An indicator variable that equals one if a firm’s options are traded on the exchanges but corporate insiders do not trade any options in a given year and zero otherwise |
Alt. Hedge-more opps | Natural logarithm of a firm’s total options trading volume (OptionMetrics item volume) in a given year. Trading volume is set to zero if corporate insiders do not trade any options in a given year. The options trading volume is scaled by the total number of shares outstanding (Compustat item csho) |
Alt. Hedge-fewer opps | Natural logarithm of a firm’s total options trading volume (OptionMetrics item volume) in a given year. Trading volume is set to zero if corporate insiders trade at least one share of options in a given year. The options trading volume is scaled by the total number of shares outstanding (Compustat item csho) |
<Primary control variables> | |
Log(mve) | Natural logarithm of the total market value of equity (Compustat item csho × prcc_f) in a given year |
Leverage | Debt scaled by total assets (Compustat item (dltt + dlc) / at) |
ROA | Return on assets (ROA) calculated as income before extraordinary items (Compustat item ib) scaled by total assets (Compustat item at) |
Loss | An indicator variable that equals one if a firm reports negative income (Compustat item ib) and zero otherwise |
MB | Market-to-book ratio calculated as the market value of equity (Compustat item csho × prcc_f) scaled by the book value of equity (Compustat item ceq) |
Cash | Cash and short-term investments scaled by total assets (Compustat item che / at) |
R&D | R&D expenses scaled by total assets (Compustat item (xrd) / at) in which a missing R&D expense is set to zero |
Div | Cash dividends scaled by total assets (Compustat item (dvc + dvp) / at) |
FirmAge | Number of years from the first year in which the firm appears in the CRSP database |
Return | A firm’s annual stock return over the given year |
Instown | Institutional ownership as a percentage |
Duality | An indicator variable that equals one if a firm’s CEO is the board chairperson and zero otherwise. We obtain the information on CEO duality from the IRRC and Boardex database |
BODsize | Total number of directors sitting on a firm’s board. We obtain the information on board from the IRRC and Boardex database |
HHI | The Herfindahl–Hirschman index for a firm’s industry (Fama–French 48 code) in a given year, based on sales-based market share (Compustat item sale) |
Litigation | An indicator variable that equals one if a firm operates in a highly litigious industry (SIC codes: 2833–2836, 3570–3577, 3600–3674, 5200–5961, 7370–7374, 8731–8734) and zero otherwise |
<Cross-sectional test-related variables (in Table 4)> | |
CEOown | A CEO’s equity ownership in the firm (Execucomp item shrown_excl_opts scaled by Compustat item csho) |
RetVol | A firm’s stock return volatility measured by daily stock return variance over the prior year |
RetVol-quintile | Quintile rank of RetVol |
Prisk | A firm’s political risk in a given year as measured by Hassan et al. (2019) |
Prisk-quintile | Quintile rank of Prisk |
<Additional control variables (in Table 7)> | |
Lag(CSR score) | Lagged CSR score |
CEOpayslice | Fraction of total compensation of top management team captured by the CEO (Execucomp item tdc1) |
Log(delta) | Natural logarithm of a CEO’s compensation Delta in a given year. Delta is the sensitivity of the value of the CEO’s equity portfolio to a 1% change in the firm’s stock price |
Log(vega) | Natural logarithm of a CEO’s compensation Vega in a given year. Vega is the sensitivity of the CEO’s incentive portfolio value to stock return volatility |
EquityIntensity | Proportion of options (Execucomp item option_awards_blk_value before FAS 123R and option_awards_fv after FAS 123R) and stock grants (Execucomp item rstkgrnt before FAS 123R and stock_awards_fv after FAS 123R) in total annual CEO compensation (Execucomp item tdc1) |
Log(salary) | Natural logarithm of a CEO’s annual salary |
CEOfinexp | An indicator variable that equals one if the CEO serves (or previously served) in positions that involve supervising role of financial statement preparation and zero otherwise |
CEOage | A CEO’s age in a given year (Execucomp item age) |
CEOtenure | A CEO’s tenure |
CEOoverconf | An indicator variable that equals one if the CEO holds vested in-the-money options (with moneyness greater than 67%) at least twice during the sample period (e.g., Malmendier et al., 2011). The variable is set to one from the first year the CEO holds the in-the-money options |
This appendix presents variable definitions. Variables are constructed using the following data sources: MSCI ESG (formerly KLD), Compustat (CCM), Execucomp, Center for Research on Security Prices, OptionMetrics, Thomson Reuters’ insider trading database (TR insider), and Boardex.
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Park, J., Kim, S. & Tsang, A. CEO Personal Hedging and Corporate Social Responsibility. J Bus Ethics 182, 199–221 (2023). https://doi.org/10.1007/s10551-021-05021-w
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DOI: https://doi.org/10.1007/s10551-021-05021-w